6.4 Exchange rates

Question 1

What is the definition of exchange rate?

Answer 1

This is the weight of one currency relative to another

Question 2

What is the determination of a floating exchange rate?

Answer 2

The value of the exchange rate in a floating system is determined by the forces of supply and demand

Question 3

What is depreciation? (pneumonic)

Answer 3

Tis is when the value of a currency falls relative to another currency.
WIDEC

Question 4

What is appreciation? (pneumonic)

Answer 4

This is when the value of a currency increases. Each pound will buy more dollars for example.
SPICED

Question 5

Factors that cause a change in exchange rates (pneumonic)

Answer 5

BIIIGS

Inflation - A lower rate means exports are more competitive. This increases demand for the currency (appreciation)
Interest rates - An increase in rates makes it more attractive to invest in the country as ROI is higher. This increases demand for the currency causing appreciation
Speculation - If people think a currency will appreciate in the future, demand will increase in the present which increases the value of the currency
Gov finances - If a gov has a high level of debt it is at risk of defaulting which can cause the currency to depreciate. This is as investors will start to lose confidence in the economy, so they sell their holdings of bonds.
BOP - when there is a CA deficit, countries struggle to finance this and the currencies depreciate as a result
International competitiveness - An increase in this leads to an increase in demand for exports which increases demand for the currency which causes it to appreciate

Question 6

Appreciation and depreciation causes:

Answer 6

Appreciate - if demand shifts right
Increase in relative IR which brings foreigners to the country and save money there. This is called hot money inflow and increases demand for the pound
Speculators anticipate a rise in the pound then they move their money into pounds increasing the demand for the pound causing it to appreciate
Increase in FDI they have to pay all their costs in pounds which involves exchanging their currency for pounds
Rise in incomes abroad, UK exports are demanded more and they have to buy in pounds
Increase in international competitiveness due to falling inflation increased investment and lower unit labour cost

Question 7

Impact of appreciation and depreciation with evaluation

Answer 7

SPICED
Net exports likely to decrease so AD likely to shift to the left. Also cheaper imports and commodity prices which will reduce their cost of production and shift SRAS to the right and lower cost of production
Lower growth which stems from fall in AD which could lead to CA deficit
Higher unemployment in exporting industries
Higher unemployment in domestic industries. Domestic firms have to compete with cheaper imports from abroad which is tekky

Lower DP and Cp inflation
Cheaper imports s improved living standards
Potential efficiency gains for domestic producers as they need to cut costs to be more competitive

WIDEC
D should increase as imports more expensive so demand for them decreases. SRAS shifts left as raw material imports more expensive
Increase in growth huge benefit.
More employment in exporting industries
More employment in domestic industries
Problems of higher DP and CP inflation
If there are protectionism measures on ur goods, could get tekky